Problem: On this 5 by 5 grid of points, what fraction of the larger square's area is inside the shaded square? Express your answer as a common fraction.

[asy]
fill((2,2)--(3,3)--(2,4)--(1,3)--cycle,gray(0.7));
dot((0,0));
dot((0,1));
dot((0,2));
dot((0,3));
dot((0,4));
dot((1,0));
dot((1,1));
dot((1,2));
dot((1,3));
dot((1,4));
dot((2,0));
dot((2,1));
dot((2,2));
dot((2,3));
dot((2,4));
dot((3,0));
dot((3,1));
dot((3,2));
dot((3,3));
dot((3,4));
dot((4,0));
dot((4,1));
dot((4,2));
dot((4,3));
dot((4,4));
draw((0,0)--(4,0)--(4,4)--(0,4)--cycle);
draw((2,2)--(3,3)--(2,4)--(1,3)--cycle);
[/asy]
Since the side of the shaded square is a diagonal of the smaller squares, it has area $(\sqrt{2})^2 = 2$ square units. The whole grid has area $4^2 = 16$ units, so the ratio of areas is $\frac{2}{16} =\boxed{\frac 18}$.